I love this post from David Hornik. I guess that I have an addiction because I love starting companies – I can’t help myself. His real message is simple – many entrepreneur friends are starting companies in this market. Personally, I think that doing startups is like taking a vacation each startup is like a good journey.

By the end of 2008, Venture Capital had been officially declared dead. Startups were laying people off so fast that even TechCrunch couldn’t manage to keep up. University Endowments and Foundations, the source of the “capital” in Venture Capital, were hemorrhaging so badly from their public company investments that many long-time believers in “alternative assets” declared a moratorium on Venture Capital. And the IPO market was a distant memory. Good times!

Welcome 2009. The public markets remain closed. Venture investors and the investors in venture investors remain “challenged.” Follow on financings have become increasingly difficult, in some instances impossible. And, while there may well be light at the end of the tunnel, it would appear that we haven’t gotten far enough down the tunnel yet to see that light.

So why am I optimistic about investing in 2009? Because entrepreneurship is an addiction, it isn’t a choice. Great entrepreneurs aren’t driven to create companies because it is easy, or because capital is plentiful, or because the public markets are swallowing anything the venture community will throw at them. Great entrepreneurs start companies because they can’t help themselves. They see a problem or a solution or white space or an opportunity and they have to do something about it.

Innovation doesn’t take a vacation during an economic downturn. Innovation is a constant. While the resources an entrepreneur may be able to bring to bear on a problem may vary with the economic climate, the desire — the need — to innovate never goes away. And Venture Capital is the fuel of that innovation. [1]

So I remain excited about the companies that will be started in 2009. There will be great companies started during this economic crisis. Some of them will be born out of the crisis itself. Others will simply be born during the crisis. But, rest assured, there will be important tech companies hatched in the next year or two. And I am certainly hoping to fund them.

Some of you reading this will say to yourselves “starting companies today is so inexpensive that we don’t need no stinkin’ VCs.” More power to you. I don’t mean to suggest that innovation will die without Venture Capital. There are many great ideas that can come to fruition without a meaningfully-large capital infusion. My hat is off to the 37 Signals and Smugmugs of this world. But for those ideas that require investment ahead of revenue to reach their full potential, Venture Capital remains an important resource for company building.

Is this financial market mess going to put the nail in the venture community? Today’s Venture capital has been struggling for sometime with ony a few small hits and very handful of big returns. The problem is that entrepreneurship is stuck because of venture capital. We need to modernize the venture capital business so entrepreneurs can get busy. I am seeing more early stage creative development then in years past. The entrepreneurial process will never die but it will evolve. These are the pains that we are seeing now with startups. The capital markets are a mess and with no liquidity market today’s venture capital firms are spinning their wheels. The good news is that capital markets are efficient and will work around the bottleneck we are seeing. This NYTimes story is an early indicator that big money will find new homes.

Investors in venture capital and private equity funds who want out are discovering that their stakes are worth less than they paid for them.

As returns on venture capital investments sour and investors’ wealth deteriorates, some of these investors — the universities, foundations and pension funds known as limited partners — have been unloading their stakes in the funds. When they decide they can no longer supply the money they had previously committed, they sell their stakes at a discount to what is known as a secondary firm.

In the second half of 2008, as more limited partners tried to sell their stakes, the price they could get for those stakes fell to 61 cents for every dollar of face value, according to a report from Cogent Partners, an investment bank for institutions looking to sell their holdings on the secondary market. That is down from 84.7 cents on the dollar in the first half of the year and a 4 percent premium in 2007.

A stake in an early stage venture capital fund that has already been fully invested, for example, would be worth 10 to 30 cents on the dollar, Mr. Gull said. “It would have relatively young portfolio companies, some number of them will need additional capital so the fund will get diluted and there are not going to be any exits for some number of years.

A 40 percent loss is no different than investments in the public markets, Mr. Gull noted, and investors would prefer to have the cash. They think, “It’s a sure thing that I can redeploy in some other activity I think has a larger chance for return,” he said.

Mr. Gull said he could not predict when pricing would improve, but his firm is betting that it will not see any meaningful returns from private equity and venture funds until late 2010.

All the talk about Silicon Valley being dead is bull. In fact many of the top VCs are actively investing like True Ventures, Norwest, Benchmark Capital, Foundation, among others. There are some top tier guys who are really hurting. I’ll post more on that later.

Here is a post from Benchmark partner Bill Gurley. I first met Bill when he was an analyst years ago before he joined Hummer Winblad then Benchmark. Bill not that technical but is very skilled at analyzing and reading the market. I think his views are right on the money (pun intended).

Bill says…
What is driving our enthusiasm to be optimistic while the general perception is that we should be “scared”? Here are four answers on a roll:

1) We make money investing, not sitting on our money. Innovation and disruption are constant and not subject to the whims of the overall economy.

2) We believe that environments like this tend to sort out the true entrepreneurs from the pretenders. When money is easy in Silicon Valley, it tends to attract short-term opportunists looking to make a fast-buck rather than build a lasting company. Only the best entrepreneurs set sail in rough seas like this.

3) We like the probability for startups (especially Series A deals) in this environment. Consider that people are easier to hire and rent is cheap. Incumbents are cutting their R&D budgets, and there will be fewer startups in each space, all of which means less competition. These are good things.

4) Graham and Dodd said it first and best, but one “… should try to be fearful when others are greedy and greedy when others are fearful.” Pretty clear what time it is.

Paul has another great post. I swear he must have the same five posts that continue to get recycled. He is always pounding that drum. He’s correct in his view. This is my third down cycle as an entrepreneur. It’s not fun but the reality is that the advantage goes to the entrepreneur. I’ve spoken to 3 other serial entrepreneurs this week and all fully agree that they are licking their chops to do a startup now. Not so 8 months ago.

I fully agree that it is the best time to start a company both for entrepreneur and the venture capitalist. In fact the angels are out there. I ran into one yesterday (granted I live in Palo Alto and you can swing a dead cat without hitting an angel or VC). There is big interest in seed, super seed, and full blown Series A deals.

In these downturn times the opportunities just fall out of the trees. In a downturn the noise level is reduced and it’s all signal. Thanks to the memo from Sequoia which was a strong signal from the Silicon Valley elite money machine on which behavior will be tolerated (translation they want less Seesmics and more real companies). The other them is that innovation is coming out strong. The real opportunities are presenting themselves. The real web 2.0 will emerge from this downturn.

If you look you will see the opportunities ..clarity is the best policy for startups.

The fact is that VCs have lost their abiity to do early stage deals at scale. My good friend Scott Rafer makes a great point – their behavior is more around the market. VCs are institutional investors – they aren’t a hands on mgt consulting firm. Some firms act like they are mgt consulting firms and that they know better than the founders – stay away from those. My advice on VC firms is to stay away from partners that can’t remember what was discussed at the last board meeting. Then unilaterally run the company from the board. VCs playing entrepreneur is not their job. So stay away from those.

My advice for entrepreneurs is try to own >51% of your company for as long as you can. Scott Rafer had a strong comment on the F VCs post – Scott says.. “This is good advice packaged but packaged in a terribly destructive way. I certainly try and design my startups to work well on bootstrapping or angel money, delaying institutional VC indefinitely. That MO tends to be much better for founder equity and employee returns, user-responsive product design, growing at a speed that is good for the company, etc.

On the other hand, WTF? Take a cold shower or something. The level of anger being displayed here has no place in this discussion or this community. Every market segment has its bad actors, both at the individual and corporate granularities. VC doesn’t have a greater share of bad actors than the ecommerce or gaming sectors. Large-scale, software VC is simply a formerly great business in decline, and there are a lot of good, smart people who haven’t made in VC yet who are worried about their (and their families’) economic futures. It’s not evil — it’s their job and they may not feel they can switch. This is a group of very smart people who are fighting for ever-fewer capital-intensive deals, and it’s getting ugly. Their economics are clear, and the bigger the fund the worse the problem.

Fred Wilson’s been publishing a good series of posts on VC economics. In the latest one [link below], he inadvertently outs one of the main problems with running a VC-backed startup. When your business is doing well, the VCs have have every incentive to push you to take more money you may not need — it’s the only way they can be as profitable as they need to be. Fred’s got a relatively small fund, great empathy with entrepreneurs, and is near the top of the heap for any number of reasons. However, he has that same problem — the interests of the Common Stock held by the founders/employees and the interests of the Preferred Stock held by the VCs is divergent in many, many more cases than the Conventional Wisdom suggests. It’s the reason why the VC asked about 100 iPhone apps, et al.

The software VCs are in a different business than we are, but one that is largely dependent on us. It’s a business that used to overlap with ours heavily but where the overlap is decreasing more quickly than capital could ever leave the sector. That leads to market consolidation, market share fights, and VCs requesting startups perform unnatural acts — all of which are ugly, and none of which are evil…

As Scott points out that might be through a series b round. My goals for companies is to bootstrap them to own at least 51% after a b-round. The only way to do that is to bootstrap the seed portion to increase the early value. Then taking money on the business and founders terms makes sense.

VCs are not the problem it’s more of the market. Building companies is a team sport and in some cases you need VCs on the team – some cases you don’t.

Scott Rafer has it correct above – certainly try and design my startups to work well on bootstrapping or angel money, delaying institutional VC indefinitely. That MO tends to be much better for founder equity and employee returns, user-responsive product design, growing at a speed that is good for the company, etc.

Building a company is a team sport and sometimes VCs are on the team – and there is nothing wrong with taht – just pick the right guys/gals. When you don’t pick the right teammates everything goes south.

Recently, there has been a ton of talk about venture problems and what makes the best venture architecture (bootstrap or venture backed). Putting all that nonsense aside for a minute I want to talk about experimentation. In emerging markets where there are more unknowns then knowns (and no great use case scenarios) you need to run experiments to get information.

Some venture investors confuse this tactic with the founders overall business vision, strategy, plan, and metrics.

Get information and requirements to reduce your risk for the investment in a new venture. This is independent of the financing strategy of bootstrap or venture capital. I love talking to entrepreneurs who have long range plans then run experiments to get more clear information.

Scott writes: “One of the most tragic things I hear in management circles is this:

“I want to make a breakthrough happen. I really really do. But I don’t want to take any risks. How do I do that?”

The principle at work here is knowledge capture: if an innovation is something new, or something you haven’t done yet, you have to capture the knowledge and skills needed to do it. An experiment is one of the few ways to capture knowledge you don’t have. If there are no experiments, you are repeating yourself, and can’t possibly be putting new ideas into practice.”

This post hits home with me because I’m an entrepreneur living in this market with four kids and it ain’t pretty. The capital markets are in the tiolet and founders around the world are working hard to find no buyers of their ideas or products. It’s a bootstrapping market. The entreprenerial market isn’t broken or starved for good ideas and needed innovation. Instead the ecosystem is stuck in the sand. Incubators are clearly seeing the action and see the need for innovation. Some bright lights are shining out there like Y Combinator among others, but overall it’s pretty dark.

What does this mean?
Bad news for entrepreneurs short term and bad news for innovation long term. M&A doesn’t yield innovation. Passionate and skilled entrepreneurs need the runway to make their visions happen. Lack of exit stunts the available growth capital needed for those next big ‘Apples and Googles”. Big ventures take 3-5 years to develop. Problem today is that capital isn’t founder friendly. Founders getting ousted after one year doesn’t make innovation happen. I’m seeing more founders on the street then ever before. There needs to be a new financial model or new incubator model (or halfway house) for founders and entrepreneurs. Y Combinator calls it a startup for startups.

Big problem is that initial public offerings of young companies had become rare. Venture-backed IPOs in 2005 and 2006 were far below the levels of the early 1990s, never mind the boom years that followed. A recovery in the early months of 2007 still didn’t push IPO numbers anywhere close to the number of young companies being acquired by bigger, more established firms.

Love this passage from James Freeman of the WSJ. “This is bad news for the U.S. economy. Does anyone think that we would be better off if Bill Gates and Michael Dell had sold out to corporate behemoths early in their careers, instead of leading their firms for years as public companies? Would consumers enjoy the same vibrant market in Web services if Yahoo had gobbled up a nascent Google? How powerful would our computers be if Intel had become an IBM subsidiary, instead of going public in 1971?”

“Of course we can’t run these experiments. What we do know is that entrepreneurial drive, combined with venture investors’ money and experience, plus access to the public markets, equaled a tech revolution and an industry that is the envy of the world. That model may be collapsing.”

“True, investment in U.S. venture funds is holding up well despite the market downturn, with investors pouring $9 billion into this asset class in the second quarter. But over the long term, venture investments have to result in a healthy number of home-run IPOs to justify the risks and offset the inevitable failures. The industry cannot continue raising the money to fund American innovation if its returns trail the stock market indexes, as they did for the five-year period through 2007.”

“Some have ascribed the broken venture model to the “cheap revolution,” meaning that, thanks to earlier innovations, the tools to create new tech products are so cheap that entrepreneurs don’t even need funding from venture capitalists. That’s great, but we’re not seeing a flood of IPOs of young companies built without venture money, nor the creation of lots of privately held global powerhouses. By and large, founders of Internet startups are not creating companies with the dream of conquering the world, but rather with the intention of selling to Google, eBay, Yahoo or Microsoft.”

“Our society should be encouraging these entrepreneurs to dream big. Instead, they’re looking for the exit before they have to deal with the burdens of our public markets.”

“An acquisition generally means that the founders move on, see projects they championed get axed, and watch old colleagues get fired. How many company founders would aspire to conduct a sale of the business instead of a public offering, absent some bizarre and unnatural conditions in the market?”

Note: Steve Jobs was ousted by his investors (Venrock Associates) only to come back and change the world a second time. Can you imagine August Capital firing Bill Gates. Good venture capitalists understand the long term value of entrepreneurship not just the quick flip.

This is a great post from VCDave, but I would add that the faster the market moves the more the founder needs to be in charge. Finding a founder with vision, product skill, and deal making ability is ideal. Venture capitalists need to let the founder run the ship. If VCs run interference with the founder then the entire venture slows down. Building a startup from nothing is difficult and navigating the market landscape with imperfect information is key. Entrepreneurs are good at dealing with ambiguities.

Once a venture enters the market the venture plan has to be in a constant state of reinvention to ‘hit’ the tipping point for the preferred business model for the proverbial ‘big opportunity’. One thing often over looked is the important objective of getting the new venture in a position in the market to seize the growth opportunity contemplated by the entrepreneur and the investor.

Entrepreneurs and VCs need to deal with change as a positive not a negative. If the ventures position in a growing market is good then the change is a normal characteristic. To me it’s about letting the founder stay in control until the venture hits calmer waters. Founders know best in the early stages. Creative, product, sales, and deal making skills matters the most. VCs shouldn’t just replace founders because a few waves crash on the ship.

Two important points Donna and Jason make: 1) build a good sustainable venture and 2) if the market is slowly developing then there is no market.

Here is a good section from end of Jason’s post “If the entrepreneur finds themselves in a situation they can’t control it’s almost certainly because they put themselves in that position — either by borrowing too much, spending too much, rushing too fast, creating a false sense of urgency, hiring the wrong people, attacking a market that doesn’t exist, or not focusing on generating revenue early enough. Natural disasters are out of our control, bad business decisions are in your control.”

My advice to entrepreneurs: try to maintain control for as long as you can (control > 50%) at all costs. Only go over 50% dilution if you need to scale and never run out of money.

If the VC doesn’t understand or believe in the founders vision then it will never work out. For VCs they do this all the time- they take hundreds of meeting until they find that chemistry.

Here is Josh’s post.

This past week I had two distinctly different meetings with entrepreneurs. They both were successful serial entrepreneurs. Both were exceptionally smart. Both had good ideas.

The first entrepreneur, however, thought that they were expected to know the answer to every question. There wasn’t a question I asked that he didn’t have a definitive answer to. He knew what their pricing model would be. He knew why Google would never compete with them. He knew what their consumer churn would be three years out (despite the fact that they hadn’t launched yet). Whenever I tried to discuss the different risks in the business, he told me why they didn’t exist.

The second entrepreneur, had a different approach. He definitively stated answers when he had them, but when he didn’t know he said so. When asked about his pricing model, he said “well, we’re considering a few different options depending on the outcome of some tests we’re running…” When asked about cost of customer acquisition, he said “well we don’t know what our numbers will be…but here’s our model based on other comparable companies.” When asked about risks, he identified several — and then we discussed how to reduce/eliminate them.

I’ve come to believe that a key investment criteria is founder credibility. And, I think the second entrepreneur was far more credible. No one expects a pre-launch company to have all the answers. (In fact, we get scared if you think you have them). As I’ve previously discussed, rather than have an entrepreneur sell me on why they are 100% correct, I’d much rather understand how they are attacking the different risks facing the business.

And, by the way, the same applies for venture capitalists. I often feel that during company pitches — and board of directors meetings — we’re expected to have an immediate opinion. Should we double our marketing budget? Should I hire this person? Will this strategy work? While it’s OK to offer opinions and thoughts, I think it is also appropriate to acknowledge uncertainty.

One point in his post that is worth highlighting is how the second enterpreneur views the market. He looks at the market as a fluid dynamic – “running tests” with “base assumptions”. Many entrepreneurs have been scorned for this view (myself included) in being “not focused”. I hate that word. All early stage entrepreneurs are ‘very focused’ on the fluid market how to enter and plans based upon certain market conditions or scenarios. Key is the focus on the possible scenarios – for that there is no one answer.

Josh’s last point is important: VC Credibility – When VCs sit on 9 boards and shows up once a qtr for board meetings with ‘the answers’ then their credibility is on the line.

Early stage is about entering the market with a narrow value proposition that has the opportunity to take advantage of a massive growth trend when in market. For this the entry strategy should be very clear and the answers to the so called ‘billion dollar’ revenue plan should be scenario based.

According to this massive trend 2007 deals are down an amazing amount – total deal numbers down an amazing 5. “Web 2.0 deals in the Bay Area actually dropped from 74 deals in 2006 to 69 last year” -Wow.

Entrepreneurs are starting companies that require less capital and no venture capital at all. Maybe entrepreneur’s love affair with venture capital is over. It’s clear to me that entrepreneurs that I talk to are bootstrapping longer and financing ventures themselves.

I hardly think that a reduction of 5 deals validates a venture capitalist trend. Most VCs are not that savvy on Web 2.0 and are generally skeptical on web deals. The ones that do get it are doing many deals. Jeff Clavier has already pounded out 16+ deals in his new fund.

Entrepreneurs beware Microsoft buying Yahoo could shut down the tech startup scene. It could send the startup climate back to 2001 levels – nuclear winter shut down. I lived through 2001-2004. It was ugly.

Efficiency for Microsoft means leverage with suppliers. Translation: Startups are suppliers and Microsoft just became Walmart. This could have a chilling effect on the VC and tech investment community. This new industry structure puts even more of an emphasis on ‘hits’ or category specific deals. If the Venture Capitalists are confused today can you imaging what they will do going forward. This could get ugly.

Advice for Technology Startups and VCs: Understand where your company is in the pecking order in this war. If you’re not an arms dealer then you might want to rethink your strategy.

Brad Feld who was a Mobius has formed a new VC firm called Foundry. Brad’s a good investor and I’ve learned from Facebook that he has the same birthday as me (Dec 1). He and his team have a great site called AsktheVC. It’s a great resource for entrepreneurs who want to prepare to build a great venture. They don’t post everyday (like sites chasing news) but their post are very strong in value. Very credible.

Brad Feld and Jason Mendelson are the co-authors of AsktheVC. Brad and Jason have been working together since 2000 when Jason joined Mobius Venture Capital, a venture capital firm that Brad co-founded. They started writing together on Brad’s Feld Thoughts blog in 2005 with their Term Sheet series. After several other series about issues facing venture capital backed companies, Jason and Brad decided to start AsktheVC. Brad and Jason, along with three other partners have recently founded a new venture firm, the Foundry Group located in Boulder, Colorado.